Educational Articles

Bank Earnings Quality: Do The Numbers Tell The Story?

Theresa Brophy
| October 18, 2012

While most companies might view the occasional gain on an asset sale as not indicative of their underlying performance, a portion (in some cases, a significant share) of banks’ noninterest revenue consists of income booked at irregular intervals.

For example, banks maintain large portfolios of investment securities that they use to help manage their interest-rate exposure. They often sell some of these securities, booking gains or losses, usually small ones, on the sales. These gains or losses were once reported on a separate line on the income statement, below after-tax earnings, but are now lumped together with fee-based revenue in noninterest income (before taxes).

Managing the securities portfolio is part of a bank’s normal activities, but the gains or losses from securities sales, and from sales of mortgage loans and mortgage servicing rights, can vary dramatically between accounting periods and make it hard to compare earnings. Banks are also required to write down securities (that they intend to sell) to their estimated fair value, which can result in significant positive or negative accounting charges that can skew comparisons of reported earnings.

Another type of lumpy revenues is the income large banks generate by trading equities and other financial instruments. Trading revenues can be very volatile, since they reflect market dynamics. Though not unusual, surges in trading revenue, or big trading losses, can sometimes skew the banks’ earnings comparisons.

One of the more vexing problems in comparing bank earnings in different periods, however, is posed by banks’ loan loss provisions. Recall that loan loss provisions are what a bank adds each period to its reserves for loan losses.

Loan loss provisions become especially problematic when banks are allowing their loan loss reserves to drift lower (when bad loans are falling), as has been the case over the past two years. With bad loans down substantially from their recession highs, loan loss reserves built up during the downturn continue to shrink because banks are not fully provisioning for the loan losses that they are currently experiencing. Underprovisioning for loan losses in effect enhances earnings and has provided much of the impetus for the bank industry’s earnings recovery since 2008.

Managing the loan loss reserve is a normal activity for a lender. But banks have been criticized for using loan loss reserves as a cookie jar to boost earnings. However, the banks point out that accounting guidelines currently prohibit them from maintaining “excess” reserves, forcing them to release loan loss reserves when they are no longer needed.

In any case, increases or decreases in earnings between periods caused by swings in loan loss provisions sometimes obscure a bank’s overall operating performance. To get around this problem, many investors look at pretax earnings before loan loss provisions, and then separately assess credit-quality trends, including changes in reserve levels.

In the end, though, the stocks of banks that don’t rely on a lot of so-called unusual or nonoperating items to bolster earnings (banks said to have higher quality earnings) generally command higher market multiples than banks that depend on such items.

Subscribers interested in obtaining more information in regard to the bank industry are advised to consult our full-page reports in The Value Line Investment Survey.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.